“Inflation is always and everywhere a monetary phenomenon.” Milton Friedman
When Milton Friedman said this in 1963, most Keynesian economists, and they were the majority then as they are now, criticized him as being illogical. But Friedman was not proposing an economic theory, although such a thesis had already been proposed by many “classical economists”; he was speaking empirically, meaning from observation. Over the next few decades Friedman’s observation won out, even convincing many of those that initially criticized him that he was ultimately correct.
Friedman, and his associate Edmund Phelps, had observed that no central bank and its government could maintain higher inflation for lower unemployment for very long without risking prolonged inflationary periods, and when higher interest rates were imposed to combat inflation without a recession and higher unemployment. They demonstrated this phenomenon with what became known as the Phelps curve; again, this was not a thesis, but an observation. Obviously, the dual mandate for the Federal Reserve to do the opposite was shown to be problematic, but that was a political mandate, not one based on empirical facts.
Fed Chairman Jerome Powell has been criticized for calling the onset of inflation “transitory”, but he was simply joining the progressive economic narrative along with Treasury Secretary Janet Yellen and a host of other economic experts in the administration and academia. Now he’s being cautioned that the Fed’s aggressive moves on interest rates may push the economy into a recession. A free market should be dictating interest rates, but we don’t have that; what we have is a central bank with a political mandate. So given where inflation is at the consequences of not raising rates would be worse; besides, we are already in a recession despite the political attempts to redefine what that is.
The Fed says they will continue to raise rates until inflation is brought under control and they reach their target rate of 2%. Putting aside the bewildering concept that any inflation is a good thing, consider that with today’s increase of another 75BP the Fed Fund rate will be around 3.25%, and real, or “headline” inflation is at 9.1%, the gap between target and inflation is about 7%. There is speculation that when and if inflation falls to 5%, the Fed will ease off the rate of rise in rates to effect a “Soft Landing”, the definition of which is a bit sketchy; the concept is that eventually the higher interest rates and the inflation rate will meet at a point without the need to raise rates further and cause a recession, or at least avoid a deep one. That sounds more like a hope than a policy, and historically has seldom been achieved; as F.A. Hayek called such ideas, it’s more like a “fatal conceit”.
The correct policy, given the still relatively low interest rates and the increasing inflation rates, is for the Fed to continue rate hikes for some time, likely well into 2023; it is true that will make the recession we have already begun more apparent, deeper and prolonged. However, that assumes that the Fed has the perseverance to follow their stated goal on the face of what will likely be strong political opposition. The administration has shown no common sense and restraint in its disastrous fiscal policies, which has led to a U.S. national debt over $30 trillion as of January 2022; that debt is now greater than our GDP, the annual economic output of the US, which has only happened once before in our history, and that was during WWII.
At the current Fed rate, interest on that debt is about $500B, clearly a debt service way beyond the ability of this country and its economy to bear, especially given the levels of expenditure the administration’s policies call for; something has to give, and assuming that the administration will not now practice the economic good sense to cut expenditures, things will get ugly. The Fed and the Federal government are caught in the exact dilemma that Freidman and Phelps forewarned of back in 1963, forced into an economic paradox of their own creation. The last time the Fed waivered was back in 2019 when they began to raise rates; Trump went bonkers, as he was want to do, and Powell and the Fed caved, cutting rates under intense political pressure. The likelihood on that happening again is extremely high as we have entered the era of perpetual political campaigning; the result, should that happen, will be as it was prior to Paul Volker, with ever higher inflation coupled with a deep recession. The word we boomers remember all too well is “stagflation”.
We seem to have entered another of those points in history where it repeats itself, but it often does so with ever increasing tenacity and ferocity when its lessons are so egregiously ignored. “The Fatal Conceit” that F.A. Hayek spoke about in his book by the same name had to do with the lessons we should have learned; “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”